Save, invest or pay your debt?

Don’t get me wrong, I consider saving as important as investing or paying off your debts. In the multiple financial books I read/listen to, it is promoted to pay off your debts (at least the small and with high-interest rates), then put aside 6 months of the worth of your expenses (the so-called Emergency Fund) then start investing. Again, don’t take me wrong, is better to have your “back secured” for any kind of emergency and stop paying that annoying high-interests, but I think that investing should have a better position in the top 3.

Building up the lore

Like all of you, you get in life by doing some debts( mortgage, car loan, personal loan, credit card loan, and so on) so eventually, part of your income is blocked in loans. And when you are stuck in loans is hard to focus on anything, especially investing. I was a bit lucky, so maybe that’s why I have this mentality and this article has this tone set up.

After getting rid of a personal loan, we took to finish up the apartment, we are stuck with only a mortgage loan (which is a fixed rate for another 3 years and at a  low-interest rate), some credit card loans (which have no interest if paid in less than a year and I do not miss a month) and our Economy account from where I “borrow” money (debt-free).

The  Economy account loan is a deposit we made at the bank and we started to put monthly contributions after our daughter has born. We use that money for some day-to-day spending (I am a bad parent, haha) and if you look in the portfolio is that buffer I keep talking about. Well, to always manage the spendings and withdrawals from it, I have a spreadsheet and detail each spending I make. Then we put it back, each month with a fixed amount of money.

Why do I treat it like a loan? Because I want to put more in it than we spend. It also becomes big enough to cover 1-2 months of expenses and it grows regularly. Treating it as a loan has helped me mentally not to give up when on it when the spending pile and it’s close to empty. Treating it like a loan (even if it’s interest-free) created the obligatorily to contribute each month.

Some time ago, we had an article on how we split our economy/investing and debt money (for the ones who would like a read, here is the link). At that moment our current allocation of income close to 24% goes to savings, 6,6% is debt money and the savings are divided into investments and actual economy accounts. The pie was looking like this:

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But that was a year and a half ago. The present brings some changes in our salary levels, some new expenses, so a new split was needed.

invest money

As we can see, we have a larger proportion of money that goes to Debts and Savings+Investments are a little big bigger than previous sum. So, from the start I opted to use the whole money I could set aside to grow in each category. But is this the best approach for us? Let’s get down to some math and approximations.

Putting it on paper

In the article How much do you really need? we came up with the amount of 2430$ for Level 2 security. Let’s take this sum, round it up to 2500$, and say that we need this amount, a month, to live by (we also have an investment component there because we always want to grow the accounts, no matter what).

Now let’s consider our income is around 3500$ so the math is a bit easier. Applying the previous rates to the current sum, we are in pair with what we need (do not forget investments category goes together with expenses).

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Now here is the interesting part. Let’s take multiple scenarios and see what we miss out for following the approaches.

Scenario I – All money goes first to building the Emergency Account

The following contributions are needed:

  • We need an account to cover 6 months of expenses, that is a 2300$ x 6 = 13800$
  • We do not invest as all the money should pile into savings
  • We lower our debt money with 300$, to 100$, as this sum usually goes into no interest debt
  • Our total sum that goes to savings is now 1,185$
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Red Line: Target – 13800$ , Blue Line: Emergency Fund Value

According to this graph we need almost 1 year to contribute to our Emergency Fund, to reach the 6 months stability, with the condition that we do not invest in anything and we do now put anything into the Economy Buffer. So if we have an unexpected expense, that will get be outside the Expense category (for example a wedding), we will be forced to take from the Emergency Fund (which will throw in 1-2 months, or more).

Two things I do not like at this scenario:

  • I will always be uneasy with the expenses, knowing that I do not have any buffer for spending and I have to take from Economy Fund
  • I miss a potential profit of 250$ income from investments (a 300$ monthly contribution with a 7% return once a year)

What do I like at this scenario:

  • I will have an Emergency Fund, which if we are frugal, we can extend to 8 months worth of living in case something goes bad (a bad market crisis or something)

Scenario II – We build an Economy Buffer in the same time as an Emergency Account

The following contributions are needed:

  • We need an account to cover 6 months of expenses, that is a 2300$ x 6 = 13800$
  • We do not invest as all the money should pile into savings
  • We set our debt money to 300$ as this sum usually goes to Economy Buffer (the no debt account we consider as a Buffer)
  • Our total sum that goes to savings is now 987$
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Red Line: Target – 13800$ , Blue Line: Emergency Fund Value , Yellow Line: Economy Buffer Line

In this scenario, we need 14 months of savings to reach our goal, and at the same time, we are also building a safety net for expenses (after all we do not have a wedding each month). What we have to keep in mind, is that maybe if we keep the blue line stable, the yellow line will go up and down with each month (as expenses occur), that’s why we do not have a specific value for each month.

What I do not like at this scenario:

  • We miss a potential profit of 294$ income from investments (a 300$ monthly contribution with a 7% return once a year). But this is not that bad.

What do I like at this scenario:

  • I will have an Emergency Fund, which if we are frugal, we can extend to 8 months worth of living in case something goes bad (a bad market crisis or something)
  • The fact that we have an Economy Buffer, right from the start that can help with the unexpected things
  • Also, considering we are saving some money, once in a while when the Economy buffer is bigger we can redirect the saved money to the mortgage credit for example (I included it the expense category as I have a fixed debt rate)

Scenario III – Save, Invest and Pay the Debt

This is the scenario I like the most because it also offers us some investment opportunities. Maybe, they are not very visible but I bet that in time all that investments will compound.

  • We need an account to cover 6 months of expenses, that is a 2500$ x 6 = 15000$
  • We invest around 300$ monthly
  • We set our debt money to 400$ as this sum usually goes to Economy Buffer (and some small credit card bills – that usually can be covered with less than 400$)
  • Our total sum that goes to savings is now 588$
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Red Line: Target – 15000$ , Blue Line: Emergency Fund Value , Yellow Line: Economy Buffer Line , Green Line: Investments

 What we can observe from start is that we need close to two years to fill up the Emergency Buffer, but at the same time we have a good portfolio that generates income from investments. At a 7% return rate, we can have 776$ that we can move into the Emergency Buffer and fill it up faster, or we can have some money from the Economy Buffer and contribute to reach our target faster.

What I do not like at this scenario:

  • Having the money spread out, is easier to start spending them without a proper goal in mind
  • You can lose part of the investment money, and then everything is a bit harder
  • If you do have an Emergency you may not be able to liquidate fast enough your investments to cover everything

What do I like at this scenario:

  • I get to grow the 3 pilons in the same time and benefit from the start of investing possibilities

If you ask me, I would take the 3rd scenario because of the potential it can have by starting investing earlier. But of course, I choose this having a stable job, good home insurance, and the possibility to have help if something bad happens.

Another thing we didn’t take into consideration is, for example where we would have been if after putting the funds into the Emergency Account, we would start investing.

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So what do you think guys? Is this the best approach? I definitely went with scenario III, didn’t respect the goals and now, all the money are mixed up, but I will start to straighten the accounts.

What would you choose? See you next time!

P.S. Header Photo from Nattanan Kanchanaprat on Pixabay

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